Shift from US exceptionalism (and divergence) to convergence - TDS

Analysts at TDS believe that one of the key drivers behind the shift from US exceptionalism (and divergence) to convergence rests on the state of the global business cycle and relative output gaps.

Key Quotes

“The US economy was one of the first major economies to soak-up excess capacity following the global financial crisis. Since the peak in 2009, the nearly 6pp drop in the unemployment rate offers stark evidence of the progress towards full employment. Even so, exchange rates are sensitive to the state of the business cycle, leaving relative output gaps essential drivers of mediumterm movements. In this regard, the fact that most major economies (like the Eurozone and Japan) are running well above reasonable estimates of potential suggest two things.”

“First, these countries are rapidly reducing slack. Growth in the EZ, for instance, sits at 2.6% against a 10y moving average of 0.6%. By the same token, the 1yma of Japan’s GDP sits at 2% versus a 10yma of 0.7%. In a broader sense, the second chart shows the cyclical strength of broader G10 versus the US based on the spread in the PMIs. The G10 PMI Index rests at multi-year highs and more importantly has accelerated sharply over the past two years. Whether or not this kind of cyclical boom leads to inflation is important for the policy outlook but, for the currency, the growth dynamics alone have led to a shift in global equity flows. Our tracking of daily ETF flows show a $14bln inflow of US money into EZ and Japanese equity markets over the past year, which may have encouraged some of the pullback in the dollar last year.”

“Second, the global reflationary environment should amplify the normalization of central bank policy in 2018. Market participants should treat this process as a regime shift, reducing the reliance on the old toolkit. For instance, the shape of the curve and the change in interest rates could become more critical forces for major currencies rather than the level of front-end rates. Our short -term cyclical models show the beta of the 2y rate peaked a few years ago. What’s more, one of the notable features of H217 was the relative steepening of the EZ and JP curves versus the flattening of the US. These are signs of improved growth dynamics and if sustained should intensify the pull of money back into local markets while reducing the incentive to recycle abroad.”